agarwal e feils political risk and the inter nationalization of firms an empirical study of...

8/3/2019 AGARWAL e FEILS Political Risk and the Inter Nationalization of Firms an Empirical Study of Canadian-Based Export

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Canadian Joumal of Administrative SciencesRevue canadienne des sciences de 1'administration24 : Ift.S-im (2007)Published online 29 Augusi 2007 in Wiley Interscience (www,interscience.wiley.com). DOI : 10.I002/C JAS.26

(J'WllEYifiterScience*Political Risk and the Internationalizationof Firms: An Empirical Study ofCanadian-based Export and FDI FirmsJames AgarwalUniversity of CalgaryDorothee Feils*University of Alberta

AbstractPolitical risk analysis primarily receives attention forforeign direct investment (FDI) but only rarely forexporting. We examine how e.xporters and foreign directinvestors evaluate the relative importance of politicalrisk factors. We provide a rationale for e.xporters toevaluate political risk factors for FDI and for Jbreigndirect investors to evaluate political risk factors forexporting. Sun^ey data were collected from Canadianexporters and Jbreign direct investors and capture thedistinctive nature of saliettt factors for exporting andFDI. We offer unique insights on the evolutionary char-acter of political risk that are of practical value for bothexporting and FDI. Copyright 2007 ASAC. Publishedby John Wiley & Sons. Ltd.

JEL Classification: F2 3

ResumeL'analyse du risque politique a ete essentiellementetudi^e en rapport avec les investis.sements etrangersdirects (lED) et rarement en rapport avec texportatiatj.La prisente examine la manidre dont les exportateurset les investisseurs Strangers directs determinentI 'importance relative des facteurs de risque politique.Elle presente aussi les raisons qui doivent pousser lesexportateurs a evaluer les facteurs de risque politiquelies aux lED et les investisseurs etrangers d irects devaluer les acteurs de risque politique lies hi exportation.Les donnees utilisees ont ete collectees aupres des e.xpor-tateurs et des investisseurs etrangers directs catiadiens.L'^tude jette une nouvelle lumi^re sur le caract^redytuttnique du risque politique et est d'un int^ret pra-tique pour les exportateurs et les investisseurs directsetrangers. Copyright 2007 ASAC. Published by JohnWiley & Sons. Ltd.

Keywords: exporting. FDT, internationalization processof firms, political risk assessment, political risk factors Mots-cles : exportation; lED; processusd'intemationalisation des entreprises; Evaluation durisque politique; facteurs de risque politique

Formal political risk analysis has received attentiononly sitice the 1960s when U.S. multinational enterprisesexperienced significant losses due to expropriations"Please address correspondence to: Dorolhee Feils, School of Business,University of Alberta, Edmonton. Alberta, T6G 2R6, Canada. Email:dorothee.feils @ ua I bcrta.ca

(Overholt. 1982). Consequently, conceptual studies onpolitical risk definitions focus on foreign direct invest-ments (FDI) ignoring other forms of internationalinvolvement such as exporting, outsourcing, licensing,and franchising (de la Torre & Neckar, 1988; Kobrin.1979; Monti-Belkaoui & R iahi-Belkaoui, 1998; Rob(Kk,1971). Even though practitioners consider political risk


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POLITICAL RISK AND THE INTERNATIONALIZATION AGARWAL & FEILS

to be important for other international activities (Minor,2003; Price, 2005; Short, 2003), empirical studies takethe same approach (Kobrin, Basek, & LaPalombara,1980; Pahud de Mortanges & Allers. 1996; Rice &Mahmoud, 1990) with only a few exceptions such asCoplin and O'Leary (1982),'Since political risk can take many different forms,different facets of political risk need to be assesseddepending on the type of a firm's international involve-ment and the firm's stage of internationalization. Politi-cal risk is a highly relevant factor during the preentry,entry, and postentry stages of the "process" model ofinternationalization (Yip, Biscarri. & Monti, 2000). Forexam ple, strategic planning, m arket research, and m arketselection all consider motivations such as market poten-tial and risk assessment as part of the preentry process;while planning for contingencies and postentry strategiccommitment both look at strategic modality shifts from

export to contractual agreement or FDI, and viceversa, as part of the postentry process. Focusing on lessimportant facets of political risk may lead to poordecisions. *"It is generally assumed that less capital is at stakefor exporting and therefore political risk is of lesserimportance to exporters (Stapenhurst, 1992). However,the loss of expec ted future reven ues often significantlyexceeds the value of the expropriated assets (Gillespie,1989). While exporters may not lose any facilities, theyface nonpayments on goods already shipped and loss ofexpected future sales. Exporters may also be subject toincreasing political risk over time due to the emergenceof the World Trade Organization, which obligatesmember countries to significantly reduce tariff barriers.While tariff barriers have gone down, many nontariffbarriers have been increased. Also, outright expropria-tions are less common today than they were four decadesago (Minor, 2003). Firms are now more concerned aboutother aspects of political risk such as exchange controls,changes in taxation, political and social unrest, and con-tract repudiation (Hashmi & Guvenii, 1992; Molano,

2001; Pahud de Mortanges & Allers, 1996; Rice &Mahmoud, 1990).

Political Risk and the Internationalization ProcessThere is no generally accepted definition of politicalrisk" since there is a lack of agreement on its conceptualand operational domain (de la Torre & Neckar, 1988;Fitzpatrick, 1983; Howell, 2001; Kobrin, 1979; Monti-Belkaoui & R iahi-Belkaoui, 1998; Sethi & Luther, 1986;Simon, 1982). Kobrin distinguishes between tw o clustersof political risk definitions: those that define political risk

in terms of government interference w ith b usiness opera-tions and those that define political risk in terms ofevents, such as creeping expropriation, devaluation andrevaluation, foreign exchange controls, and foreign wars(Monti-Belkaoui & Riahi-Belkaoui). Simon views political risk as "governmental or societal actions and policiesoriginating either within or outside the host country, andnegatively affecting either a select group of, o r the majority of, foreign business operations and investments"(p, 68). Howell dichotomizes political risk definitions interms of those that require acts of national governmentsand those that include political acts not originated bygovernments, such as rebellions. He emphasizes thamore recently the relevant government level may not bethe national government but often the regional, stateprovincial, or local government.

It is apparent that most political risk definitionsfocus on the possibility of losses rather than creation ofnew opportunities and that prior work only consideredFDI since much of international business (IB) researchconcerns the spread of the multinational enterprise(MNE) (Alon & Martin. 1998; de la Torre & Neckar1988; Howell, 1998; Kobrin, 1979; Robock, 1971Simon. 1982). While IB research primarily examinesMNE behaviour, it has unfortunately not given adequateattention to export behaviour of finns. Given that inter-national trade and marketing is a subset of internationabusiness and that many MNEs are also exporters, it iwithin the legitimate domain of IB research to studyMNE as well as export finn behaviour. Therefore, weneed a political risk definition that encompasses thevarious types of international business activities such asexporting and FDI. In order to capture all relevant facetsof political risk as well as account for the varioutypes of international business activities, we use the following definition of political risk - a generalization othe definition provided by de la Torre and Necka(p. 224)

the probabili ty distribution that an actual or opportu-ni ty loss wi l l occur due to the exposure o f . . . [ f irmsinvolved in international business activit ies | to a setof contingencies that ranye from il ie total seizure ofcorpora te asse ts wi thout compensat ion lo the unpm-voked interference of external agents, with or withoutgovernmenta l sanct ion , wi th the normal opera t ionsand performance expected from the . . . | f inn | .

Adapting de la Torre and N ecka r's (1988) definitionof political risk makes the definition comprehensive innature and allows for the inclusion of both actual andopportunity loss, FDI and exporting, and governmentaand external actions. This definition includes both actualoss (e.g., confiscation) and opportunity loss resulting in


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POLITICAL RISK AND THE INTERNATIONALIZATION OF FIRMS AGARWAL & FEILS

reduction in the value of a stream of benefits (e.g., cur-rency and remittance restrictions) as a result of actionstaken by legitimate government authorities. It alsoincludes actual loss (e.g.. revolution, war) and opportu-nity loss (e.g., threats by hostile groups) as a result ofexternal agents outside the control of government author-ities. These external agents cause threat and disruptionoutside the control of legitimate governments and mayinclude nationalistic buyers, suppliers, employees, andother key stakeholders.

Internationalization is defined as "the process ofadapting a firm's operations (strategy, structure, resource.etc.) to internationai environments" (Calof & Beami.sh1995, p. 116) and includes both forward internationaliza-tion, such as going from exporting to FDI (Johanson &Vahlne 1977. 1990); and backward internationalization,such as going from FDI to exporting (Calof & Beamish).'Exporting and FDI represent two important entry modes,among others, in the internationalization process of firmspreparing to serve a foreign market.

The choice between expo rting and FDI in the contextof political risk can be.st be explained by Dunning's 1998OLI paradigm. The OLI paradigm is a multitheoreticalapproach that encompasses the resource advantage theory(ownership advantage), international trade theory (loca-tion advantage), and transaction cost theory (intemaliza-tion advantage). Dunning's eclectic theory argues thatsuccessful FDI must contain ow nership advantage, loca-tion advantage, and internalization advantage. Politicalrisk can be addressed by transaction cost analysis inwhich firms weigh in the costs and benefits of politicalgovernance structures and policies, and the likely politi-cal hazards in the host country (Henisz & Williamson,1999). When political hazards are high, firms choosingto internalize (and thus reduce) transaction risk willprefer either exporting or FDI over contractual agree-ments. However, the choice between export and FDIdepends upon other host country factors, includingmarket potential, competitive risk, and governmentpolicy, as well as firm-specific know-how and globalstrategic factors (Malhotra, Agarwal, & Ulgado, 2003).For instance, in a high risk-high return market, despitehigh political risk, firms may opt for FDI modality andnegotiate a specialized political governance structureakin to hierarchical organization, such as forming aregulatory agency or public-private partnership thatwill ensure specific safeguards (Henisz & Zelner,2004).

Johanson and Vahlne"s (1977, 1990) theory of inter-nationalization postulates that a firm with limited marketknowledge will choose to export, since lack of knowl-edge about a foreign market creates uncertainty and risk.A firm begins to internationalize its operations by pursu-

ing the following stages of development: (a) no regularexport, (b) export via agents, (c) sales subsidiaries, and(d) overseas production. At the core of the stages theoryof internationalization is the organizational learningprocess, whereby increased market knowledge leads toincreased market commitment. At lower levels of inter-nationalization (e.g., exporting), firms move towardmarkets that are similar in terms of geographic, psychic,and cultural distance, with minor potential for financialand political risk (Gomes & Ram aswamy, 1999). As thedevelopmental process continues, a firm enhances it.smarket knowledge: especially experiential knowledgeand firm-specific skills. Once the firm has accumulatedsignificant experiential market knowledge, it will commitmore resources and engage in higher levels of interna-tionalization, such as FD I. Thus, firms are typically p re-dicted to move sequentially through different stages asthey develop their international activities (Burton &Schlegelmilch, 1987; Johanson & Vahlne, 1977, 1990),*In this paper, we view political risk as part of the broadermarket (or country) risk factors that have been foundmissing from the stages model of internationalization.Including political risk challenges in the stages modelsdoes not require an alteration of its core concept - thatis, a firm's ability to cope with uncertainty and experi-ential learning - rather it compliments a multifacetedconceptualization of market knowledge and market risk(Delios & Heni.sz, 2003a),

Evidence suggests that while firms generally movein the direction of increasing resources toward foreignmarkets, they also move in the reverse direction for stra-tegic reasons (e.g., Benito & Welch, 1997; Calof &Beamish, 1995). Based on organization learning theory,as firms expand over time their existing structures andsystems will fail to fit the new global environment. It ishere that firms need to reconfigure internal structures,systems, and processes to fit the new market environment(Ruigrok & Wagner. 2003; Sullivan, 1994). Firms withmultinational FDI operations sometimes engage in de-intemationalization triggered by foreign market condi-tions, foreign government actions, or simply for strategicrepositioning. From a transaction-cost perspective, sig-nificant changes in the factors that influence the initialchoice of operation modes are likely to lead to correctiveaction (Teece, 1986). Similarly, from a corporate portfo-lio and product life-cycle perspective, divestment is areal strategic option (Chow & Hamilton, 1993). Suchde-internationaiization may take several forms, such asreduction of operations or ownership stakes, switchingto operations mode with a lower level of commitment,divestment, and closure.*"

The purpose of this paper, therefore, is threefold.First, given the paucity of research on export-related


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political risk, we intend to identify salient risk factorsthat influence export decisions and how exporters evalu-ate these political risk factors. To the best of our knowl-edge, previous academ ic studies have focused exclusivelyon political risk for FDI. While existing empirical studieson political risk are aimed at FDI, some studies haveincluded both exporters and direct investors in theirsamples and have not differentiated between the twosubsamples (see Rice & Mahmoud. 1990; Subramanian.Motwani, & IsHak, 1993). In this study, we draw thedistinction between exporters and direct investors.Second, we consider how the critical set of risk factorsidentified for exporting differs from that of FDI. In otherwo rds, we test for differences in exp orter s' evaluation ofpolitical risk factors for exporting and the direct inves-tors' evaluation of political risk factors for FDI. Third,we study exporters' cross-evaluation of the politicalrisk factors for FDI and foreign direct investors' cross-evaluation of the political risk factors for exporting.Cross-evaluation refers to the subjective evaluation ofthe relative importance of political risk factors inherentin one entry modality (e.g.. FDI) as perceived by a groupengaged in another entry modality (e.g.. export). Basedon the internationalization process of firms (Johanson &Vahlne, 1977. 1990), those that currently engage inexporting may turn their attention to FDI in the future.Based on the de-internationalization process of firms(Benito & Welch. 1997: Calof & Beamish. 1995), it isalso likely that foreign direct investors may initiate amode change to exporting for some of their operations.We begin by reviewing the relevant factors for politicalrisk assessment. We then explain the methodology usedin this study and follow this with analysis, discussion,implications, and an outline of the limitations of thestudy.

A Framework of Political Risk FactorsIn formulating a framework of political risk factors,several authors emphasize the need to consider not only

political but also economic variables (Alon & Martin,1998; de la TorTe & Neckar. 1988; Monti-Belkaoui &Riahi-Belkaoui, 1998; Overholt. 1982; Simon, 1984) tosearch "for what one might call the potential for trouble"(de la Torre & Neckar). We have selected de la Torreand N ecka r's framework to examine the various politicalrisk factors because It incorporates (a) economic andpolitical dimensions and (b) internal (domestic) andexternal (foreign) dimensions. This classification yieldsfour categories of country-level political risk factors:internal-econom ic, external-econom ic, internal-political,and external-political.

Internal-Economic FactorsInternal-economic factors include an assessment othe host country's economy and its rate of developmen(de la Torre & Neckar. 1988). We take an aggregate lookat the host country and summarize this factor by using

its level of economic development, which is measured byfactors such as per capita income, price index, incomdistribution, and economic growth. A large gap betweenthe aspirations of people and economic reality significantly increases the likelihood of a revolution (Knudsen1974). High per capita income and strong economigrowth have a positive impact on a country's risk ratin(Cosset & Roy. 1991). Developing countries may alsoview foreign investment as a potentially exploitativentity and therefore resort to rules that promote indigenous business (Stevens. 1997).External-Economic Factors

Political risk analysis must also be directed to external economic position (de la Torre & Neckar. 1988). Ithis category, factors include foreign trade and barrierto trade, external debt, overall balance of paymentscapital flights, and general indicators such as foreigexchange rates. We therefore use the following factorin our study: level of protectionism, level of debt outstanding, capital outflow restrictions and stability oforeign exchange rates.Level of protectionism of the host country includeimport restrictions via tariffs and quotas (Rice &Mahmoud, 1990). buy-domestic rules, and local contenrequirements. The current level of protectionism in thhost country, together with other factors, helps determinthe likelihood of more protectionist host governmenpolicies in the future.The level of debt outstanding in the host country also an important factor since countries with high levelof debt outstanding need to manage their debt and negotate with foreign banks and multilateral institutions sucas the International Moneta!7 Fund. The outcomes othese negotiations and the resulting policy changes ardifficult to predict and have potentially major destabilizing political, social, and econom ic conseque nces (Mille1992).Capital ou tflow restrictions refers to restrictions oforeign exchange reserves imposed by the host countrgovernment (Eiteman, Stonehill, & Moffett, 2(X)4) or aintroduced when the government gives in to politicapressure (Sethi & Luther. 1986). Thus, capital outflorestrictions are indicative of the government's willingness to intervene in the markets in response to economdifficulties and lobbying by pressure groups. The curre


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POLITICAL RISK AND THE INTERNATIONALIZATION OF HRMS AGARWAL & FEILS

level of capital outflow restrictions provides a benchmarkfor likely increases or decreases of these restrictions inIhe future (Ha.shmi & Guvenii. 1992; Kennedy, 1985).Stability of oreign exchange rates refers to the like-lihood that governments will introduce new policies,such as exchange c ontrols, in response to a rapidly d ete-

riorating value of currency (Eiteman et al., 2004). Ingeneral, unstable foreign exchange rates lead to majoreconomic problems, resulting in increased political riskto international business operations (Eun, Resnick. &Brcan, 2005).Internal-Political Factors

An understanding of the political situation of thehost country warrants the study of the cohesiveness ofthe social structure, the disparity between people's beliefsand aspirations on the one hand and the quality of leader-ship on the other, the relative power of the government,the strength and tradition of national institutions, andmore general indicators such as official corruption andriots (de la Torre & N eckar, 1988). Therefore, we use thefollowing factors in our study: political stability, level ofdemocracy, and level of red tape and corruption.

Political stability refers to "political fluctuations,which change the business environment significantly"(Robock, 1971), Political instability, or the uncertaintyabout the future of the political system, may lead topolicy instability. Firms may face different tax rules,import restrictions, or even expropriation due to a changein the regime, and thus they may minimize comm itmentsto a market where policy credibility Is low (Henisz &Delios, 2001). However, not every regime change willlead to a change in government policy. Political stabilityitself will usually be determined by other political andsocioeconomic factors (Balkan, 1992; Brewer, 1985).Finally, policy changes need not be abrupt but can oftenoccur gradually with the same detrimental effects assudden policy changes (Minor, 2003).

Level of democracy refers to the degree to whichelected officials in the executive and legislative branchesof government reflect the popular will of the people. Aiiand Isse (2004) argue that democratic regimes tend to beeconomically more dynamic than totalitarian regimesand thereby tend to better satisfy the desires and will ofpeople. Satisfied people are less likely to initiate revolu-tions. They find that democracies are less prone to radicalpolicy changes but are politically not any more stablethan totalitarian regimes. Balkan (1992) finds an inverserelationship between political risk and the level ofdemocracy. Howell and Chaddick (1994) show a positivecorrelation between authoritarian governments and polit-ical losses to investors.

Degree of red tape in the host country governmentgenerally refers to the extent of the layers of operational/administrative rules and procedures that may be politi-cally initiated and is a measure of government effective-ness and efficiency. At the very extreme, it can alsoinclude corruption and bribery. Each country has a certainamount of tolerance toward the corruption of the estab-lishment. However, once that tolerance level is exceeded,there may be a risk to the stability of the political system(Raddock. 1986). Ongoing corruption, even without aregime change, is politically risky for MNEs because ofthe potential for increasing bribe demands over time,Zhao, Kim, and Du (2003) find that less corrupt, moretransparent countries are able to attract more FDI.External-Political Factors

Political risk is often externally induced (de la Torre& Neckar, 1988). Factors to examine include position oninternational issues, regional and international politicalconflict and cooperation, and general attitude towardforeign businesses. Often, the government's position oninternational issues can influence political conflict orcooperation with key players. We therefore use the fol-lowing factors in our study: regional and internationalpolitical conflict and cooperation, and general attitude ofhost country governments toward foreign business.Regional and international political conflict and

cooperation refers to international events that encompassthe relations between the host country and the homecountry, such as the breaking of diplomatic ties, andbetween the host country and third countries, such as thecreation of a regional trading bloc (Nigh, 1985; Schcill-hammer& Nigh. 1984).Attitude of host country government toward foreign

businesses refers to the global attitude of the existingpolitical regime toward foreign investment and trade (dela Torre & Neck ar, 1988: Kobrin et al., 1980). The atti-tude toward foreign businesses may act as a signal ofpolitical risk and is the result of the ideological climate,nationalism, and the propensity of the current govern-ment to intervene in the markets (Toyne & Walters,1993).

MethodSample and Data Collection

The export sampling frame consists of Canadianfirms currently exporting and listed in the BusinessOpportunities Sourcing System (BOSS) database offirms that export outside of the United States. Compiled


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POLITICAL RISK AND THE INTERNATIONALIZATION OF FIRMS AGARWAL & FEIL

by Industry Canada, the information in the database isbased on voluntary disclosure by the listed firms. TheFDI sampling frame of Canadian firms is taken fromWho Owns Whom. North America .'' Only Canadian firmswith at least one foreign subsidiary outside of the UnitedStates are included in the FDI sample. Thus, our sam pleconsists exclusively of firms with a common institutionalbackground. Canadian exports to and FDI in the UnitedStates was not considered, due to the closeness of thetwo countries. The export and FD I markets outside of theUnited States represented countries from Latin America,Europe, the Middle East, Africa, and Far-East Asia. Bothsamples consisted of Canadian firms with export or FDIsales in excess of CAD 50 million. Two sets of impor-tance ratings on the 10 political risk factors {identifiedand discussed in the framework) were taken both fromexport decision makers and direct investors: one forexport function and one for FDI function. A seven-pointscale w as used w ith 1 = not at all important and 7 =extremely important.

Questionnaires were m ailed in a package containinga cover letter stating the objectives of the study alongwith the actual questionnaire. The cover letter clearlymentioned that export decision makers and FDI decisionmakers with international business experience wouldqualify as respondents. About six weeks later, a follow-up letter was sent to nonrespondents. Out of the 197exporters that received the questionnaire, 24 firmsresponded after the follow-up round of mailing. Thisyielded a response rate of 12.2 %, which is within theexpected average range for mail surveys. Of the 211foreign direct investors that received the questionnaire,23 firms responded. This yielded a response rate of10.9%. However, two questionnaires were unusable dueto high item nonresponse. Therefore, 21 usable question-naires were used for the FDI sample, yielding a netresponse rate of about 10%.The main reasons obtained for nonresponse werethat the level of international business of the firm wasnot sufficient, that political risk analysis was not carriedout, or that the business had been acquired by another

firm. A low response rate does not automatically implya significant response error. The response bias as a resultof sample control was reduced, as about 51% of respon-dents identified themselves as presidents/vice-presidentsand CEOs and the remaining 49% came from the mana-gerial level, mostly responsible for international busi-ness. The respondents had an average experience ofabout thirteen years in international business. To be suc-cessful internationally, the product, strategy, attitude,and perception of the firm's executives must be appropri-ate {Calof & Beamish, 1995; Eriksson, Johanson, Majk-gard, & Sharma, 1997; Kobrin, 1994).

The characteristics of the responding firms are summarized in Table 1. About 42% of the export firms in ousample have total sales in excess of CAD 500 millionHalf of the firms have more than half of their total saleabroad. About 79% of the firms have less than 10% otheir total assets abroad. Two-thirds of tbe export firmengaged in industrial products and one-third in consumenondurable produc ts. About 58% of tbe export firms haoverseas experience of more than 15 years. About 7 1 %exported mainly to developed countries and thremaining 29% to developing countries. About 58% othe firms had export involvement in more than 1countries.

About 76% of the FDI firms in our sample (seTable 1) have total sales in excess of CAD 500 millionAbout 38% of tbe firms have m ore than 50% of their totasales abroad. About two-thirds of the firms have morthan 25% of their total assets abroad. About 81% of thFDI firms engaged in industrial products. About onethird of the FDI firms had overseas experience of morihan 15 years. About 57% of FDI firms operated mainlin developed cou ntries and 38% to developing co untrieAbout 24% of the firms had FDI involvement in morthan 10 countries.

Analysis and ResultsWithin-Group Analysis: Export Decision Maker

We first conducted a within-group analysis whereiexport decision makers evaluated 10 factors (a) for expofunction (i.e.. baseline evaluation) and {b) for FDI function {i.e., cross-evaluation). For all items, seven-poiscales were used. These 10 items used in the ratings havbeen discussed in the theoretical framework under thsubsections: internal-economic factors, externaeconomic factors, internal-political factors, and externapolitical factors. These items are:

1. attitude of host country toward foreign business;2. level of economic development of host country (e.gper capita income);3. level of democracy in host country {i.e., does thgovernment refiect the popular will of thpeople?);4. stability of ruling political party in host country;5. stability of foreign exchange rates and relative pricin hostcountry (e.g., unexpected currency devaluatioinflation);6. extent of regional and international cooperation hostc oun try (e.g., border disputes, political refugeeposition on international issues);


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POLITICAL RISK AND THE rNTERNATIONALIZATION OF FIRMS AGARWAL & FEILS

Table 1Sample Description

Total sales (in mill. CAD):

Total sales abroad:

Total assets abroad:

Type of" firm:Firm's foreign experience;

Involvement by region:Number of countries:

50-


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POLITICAL RISK AND THE INTERNATIONALIZATION OF FIRMS AGARWAL & FEIL

Figure 1.Political risk ratings of export decision maker and FDI decision maker

1 and 2 (For Export Function) 3 and 4 (For FDI Function)1 Export Manager's Perception Toward Export Function

2 FDI M anager's Perception Toward Export Function3 Export Manager's Perception Toward FDI Function

4 FDI Manager's Perception Tow ard FDi Function

- ^J?^ "

.^ ^

export decision makers assign significantly higher impor-tance ratings to FDI over exporting, they consider redtape and protectionism most important for exporting fol-lowed by stability of foreign exchan ge and capital outflowrestrictions.

Within-Group Analysis: FD I Decision MakerAs for the export decision maker, we conducted awithin-group analysis wherein FDI decision makersevaluated the same 10 factors (a) for export function(i.e., cross-evaluation) and (b) for FDI function (i.e.,baseline evaluation). Lines 2 and 4 (Figure I) representFDI decision makers' ratings of exporting and FDIrespectively. In general, FDI decision makers attachhigher importance to these factors for FDI than forexporting. In addition, importance ratings given toexporting are much lower at the absolute level compared

to those given by exporters. The ov erall mean for FDI4.50 as compared to 2.65 for exporting. As reported Table 2, capital outflow restrictions. level of protectioism, and stability of foreign exchange are the three moimportant factors for exporting, and capital outflorestrictions, attitude of host country, and red tape are tthree most important factors for FDI.The results of a Repeated Me asures Within-SubjecMANOVA indicate that the set of ratings for exportinand FDI are significantly different for the FDI decisiomaker samp le. F transformation of Wilk's Lambda (0.1is 6.00 (df = 10. 11; p < .01). Univa riate resu lts (sTable 3) indicate tbat tbe following eight factors asignificantly higher for FDI: attitude of host count(p < .01); level of economic dev elopment (p < .01); levof democracy (p < .01); stability of ruling party (p < .01regional and international cooperation (p < .01); degrof red tape (p < .01); level of foreign debt (p < .01); a


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POLITICAL RISK AND THE INTERNATIONALIZATION OF RRM S AGARWAL & FEILS

Table 2Rank Ordering of Political Risk Factors (1 = Most Impo rtant and 10 = Least Important)

Political risk factorDegree of red tapeLevel of protectionismStability of foreign exchange ratesCapitat outflow restrictionsAttitude of host countryStability of ruling partyLevel of economic developmentRegional and international cooperationLevel of democracyLevet of foreign debt

Export decisionmakers' rankingof exporting(basetine ranking)

123456789

10

Export decisionmakers' rankingof FDI(f TOM-ranking)3651248.58.57

10

EDi decisionmakers' rankingof EDI(baseline ranking)35.58124

105.579

FDI decisionmakers' ranking ofexporting(cnrw-v-ranking)

523146978

10

capital outflow restrictions (p < .05). These results wereconfirmed by the Wilcoxon signed ranks test. While FDIdecision makers generally assign significantly higherimportance ratings to FDI than to exporting, they con-sider stability of foreign exchange rates and protection-ism significantly important for exporting."Between-Group Analysis: Exporting

Lines 1 and 2 (Figure 1) represent export d ecisionmakers' and FDI decision makers' ratings of politicalrisk factors for exporting. In general, export decisionmakers' ratings are higher than FDI decision makers'ratings. The results of a Between-Subjects MANOVAindicate that the two decision maker groups are signifi-cantly different across the multivariate dependent vari-ables. F transformation of Wilk's Lambda (0.50) is 3.39(df = 10, 34; p < .01). Univariate results (Table 4) indi-cate the importance of the following factors as signifi-cantly higher for export decision makers: degree ofred tape {p


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POLITICAL RISK AND THE INTERNATIONALIZATION OF HR MS AGARWAL & FEIL

Table 3Within-Group Anaiysis: Univariate Results of Repeated M easures M ANOV A

Political risk factorsDegree of red tape

Export functionFD ! function

Level of protectionismExport functionFDI function

Stability of oreign exchange ratesExport functionFDI function

Capital outflow restrictionsExport functionFDI function

Attitude of host countryExport functionFDI function

Stability of ruling partyExport functionFDI function

Level of economic developmentExport functionFDI function

Reiiional and international cooperationExport functionFDI Function

Level of democracyExport functionFDI function

Level of oreign debtExport function ,FDI function

mean

5.465.88

5.255.13

4.635.42

4.586.04

4,505.96

3.795.46

3.504.38

3.174.38

3.044.50

2.883.96

Exporters (N

standarddeviation

1,891.94

2.131,94

1.942,02

2.382.0i

1.983.32

1.931.84

1.962.00

1.691,86

1.761.96

1.651.81

= 24)f-value(1 .23)p-value inbrackets

1.14[.296]

0.07[.793]

3.93[.059]

6.12[.021]*

9.18[.006]*

23.47[.000]*

3.89[.061]

8.06[.009]*

18.36[.000]*

8.77[,007]*

Foreign

mean

2.815.00

3.144.43

3.003.903.245.67

2.905.57

2,624.71

2.05

2.52

2.244,05

2.003,71

direct investors

standarddeviation

2.861.90

3.142.04

3,032.23

3,282.069.432.982.0 i

2.691.98

2.221.94

2.581.89

2.361.96

2.121.85

{N = 21)f-value(1 ,20 )p-value inbrackets

7.49[.013]*

2.36[.140]

1.51[-234]

6.60[-0181*

[.006]*

7.50[.013]*

8.70[.008]*

7.94[.Oil]*

10.98[.003]*8.80[.008]*

* Significantly different at the p = 0.05 level.

DiscussionPolitica] risk and its analysis liave clianged over the

las t few decades . Meyer (2003) comments ,"Political risk has been a major concern of interna-tional business scholars up to the 1970s, yet this line

of research has become rather quiet in recent years.Maybe, businesses found the world rather predictablebetween "Iran 1979" and 'In donesia 1997.' Yet. theend of the cold war has not eliminated political risk."(p . 223).In our s tudy, we address the evolut ionary character pohtical r isk in recent years and the d is t inct iveness


11/18


Table 4Between-Group Analysis: Univariate Results of Between Categories MANOVA

PoUlicat riskDegree of red tape

Export decision makerFDI decision maker

Level of protectionismExport decision makerFDI decision maker

Stability of oreign exchange ratesExport decision makerFDI decision maker

Capital outflow restrictionsExport decision makerFDI decision maker

Attitude of ho.it countryExport decision makerFDI decision maker

Stability of ruling partyExport decision makerFDI decision maker

Level of economic developmentExport decision makerFDI decision maker

Regional and international cooperationExport decision makerFDI decision maker

Levet of democracyExport decision makerFDI decision maker

Level of foreign debtExport decision makerFDI decision maker

mean

5.462.81

5.253.14

4.633.004.583.24

4.502.90

3.792.62

3.502.05

3.172.52

3.042.24

2.882.00

Exporting

standarddeviation

L8 62.86

2.133.14

1.933.032.383.28

1.982.98

1.932.69

1.962.22

L6 92.58

1.762.36

1.652.12

f-value( L 4 3 )p-value inbrackets13.89

[.001]*

7.10[.Oil]*

4.72[.035]*

2.52[-12]

4.58[.038]*

2.87[.098]

5.43[.025]*

1.00[.322]

1.70[.I99J

2.421-127]

mean

5.885.00

5.134.43

5.423.90

6.045.67

5.385.57

5.464.71

4.383.52

4.384.43

4.504.05

3.963.71

Foreign direct

standarddeviation

L9 41.90

1.942.04

2.022.23

2.012.06

3.322.01

L841.98

2.001.94

1.861.89

1.961.96

1.811.85

investmentf-value(1 .43 )p-value inbrackets2.33[.013]

1.38[.247]

5.69[.022]*

0.38[.540]

0.56[.8151

1.71[.198]

2.09[.I55[

0.01[.924]

0.60[.444[

0.20[.657]

Significantly different between groups at the p = .05 level.

salient factors for expor te rs and foreign directinvestors .Contributions to Theory

Tile conceptual domain of political risk in intertia-tional business has been limited to FDL Given that more

recently multinational firms engage in international busi-ness activities In a variety of ways (such as exporting,licensing, franchising, outsourcing, and ofl'-shoHng),limiting the political risk definition to FDI may lead toinaccurate political risk perceptions and analysis. Weprovide a definition and a comprehensive framework ofpolitical risk adapted from de la Torre and Neckar (1988)


12/18


that encompasses various international business activi-ties and may serve as a basis for political risk analysis inthe 2 1 " century.Applied Implications

Red tape emerges as the most important political riskfactor in export function and to a significant extent inFDI. This factor has received limited attention in previ-ous research on political risk factors for FDI. Red tapereflects the quality of bureaucracy and in the extremecase, corruption involving bribery. This finding is con-sistent with the study of Globerman and Shapiro (2003)who found that govemment effectiveness, efficiency, andcorruption was the second most important factor in influ-encing FDI in general with the results more pronouncedin developing and transition economies. Excessivebureaucracy may be viewed more as an operationaladministrative problem than a political problem.However, there is evidence that governments are oftenthe cause of red tape , leading to bureaucratic inflexibility(Baldwin, 1990). Red tape in many countries can alsotake the extreme form of government corruption andbribery. The study by Zhao et al. (2003) affirms the posi-tion that high corruption and low transparency signifi-cantly hinders the inflow of FDI to host countries. Whiletheir study involves FDI firms only, our results show theseriousness of this problem in FDI but more notably inexporting. Transparency International (2004) cites reportsof increased demands for bribery around the world andconcludes that corruption is rising dramatically. In tran-sitional economies and the former Soviet Union, eco-nomic restructuring has caused a complete breakdown ofrules and controls, thus creating chaotic conditions andan explosion of corruption (BoswelL 1999). Despiterenewed interest in fighting corruption through legal andpublic policy frameworks such as the OECD, WoridBank, and W TO. little has changed to date (TransparencyInternational Report, 2004).

Political risk factors for FDI have changed in impor-tance over time. Historically, political stability of thehost country was consistently one of the most importantpolitical risk factors in addition to import restrictions,capital outflow restrictions, and attitude of host countrytoward foreign investment (Hashmi & Guvenli. 1992;Kennedy, 1985; Kobrin et. al., 1980). We find capitaloutflow restrictions and attitude of host country govern-ment are considered the two most important factors for0 } in this study. In the current political climate, thereis much concem that new governm ents will change poli-cies and affect the business operations of the firm. Whilethere has been a trend toward more freedom of capitalmobility, there is increased govemmental concem about

the implications of capital flight on the exchange rateand the economies. In the midst of the Asian crisisMalaysia introduced foreign exchange controls. HongKong and Taiwan introduced restrictions against speculators, and Japan expressed support for foreign exchangcontrols (Wade, 1998), which then made profit repatriation more difficult or impossible.

An interesting finding in our study is that expordecision makers and FDI decision makers perceive thFDI function in similar ways. Considering the FDI decision makers' perception of FDI as the baseline, expordecision makers accurately estimate the importancassigned to the factors for the FDI function, ln factexporters' assessment of FDI closely follows the baselinassessment of FDI by direct investors (see Figure 1Lines 3 and 4). We term this as the convergence effecBased on the stage-based internationalization theoryexporting firms on the trajectory to FDI operations arwell prepared to make the transition with realistiexpectation and assessment of the FDI function. Thmarket infomiation vis-a-vis political risk factors foFDI is accurately scanned and processed by exporfirms. This indicates a high level of preparedness that inturn may lead to greater market commitment in thfuture.

Convergence effect is rather intuitive and can bjustified, given that firms enhance their market knowledge and organizational learning incrementally ansequentially as they progress through the developmenstages of intemationalization. Delios and Henisz (2(K)3ashow that policy uncertainty in a foreign country affectthe investment sequence of a firm; namely, firms prefeto enter markets via a distribution affiliate (i.e.. lescapital investment) in countries with higher policy uncertainty. If exporters accurately assess the political risassociated with FDI. they will be in a position to makgood strategic choices in furthering their intemationalization status. Another explanation for the convergenceffect is the reality that much of the extant literature opolitical risk assessment is focused on FDI rather thaexporting, making exporters better prepared for forwarintemationalization.On the other hand, export decision makers and FDdecision m akers evaluate the export function differentlyResults reveal that the degree of red tape and level oprotectionism are the two most critical factors that differentiate export and FDI decision makers, followed bstability of foreign exchange rates, level of economidevelopment, and attitude of host country (see Figure 1Lines 1 and 2). Export decision makers consider thesfactors significantly more important for exporting thaFDI decision makers. Nearly all of the factors for expofunction were rated as a 3 or below (on a seven-poin


13/18


scale) by FDI decision makers. We term this the diver-gence effect.

There are two principal explanations for the diver-gence effect. First. FDI firms have already passed theexporting stage and thus may have acquired the knowl-edge required to better assess the political risk for export-ing. However, much of this knowledge acquired wasexperiential since there has been very little research intothe political risk factors for exporting. Second, given thevalidity of the stages model of forward internationaliza-tion, FDI firms may no longer realize the need to estimatecorrectly the political risk for exporting. There is ampleevidence in support of the stages models of internation-alization in general, although moderating influencesfacilitate leapfrogging of stages (Bjorkman & Forsgren.20(X); Malhotra et al.. 2(X)3). Future research should beable to shed more light on the fine-grained motivation sunderlying this phenomenon.

Generally, firms would prefer to invest less equityin politically riskier environments (Delios & Henisz,2()O3b); that is to say. they may choose exporting orcontractual agreements over FDI, A lack of agreementon the proper assessment of the institutional environmentmay lead to a suboptimal entry strategy. The divergenceeffect raises an important issue for multinational corpora-tions with FDI who need to further take advantage ofglohalization by entering new countries. The importantdecision they have to make is whether to export or setup a foreign subsidiary. If exporting is the preferredchoice, direct investors need to understand the differencesin political risk factors between export and FDI. The at-tractiveness of export modality for an existing FDI firmbecomes more pronounced within the context of regionaltrading blocs and their location-specific advantages(Dunning, 1998). They offer large regional markets andthe availability of specialized spatial clusters often initi-ated by member governments. A reduction in spatial trans-action costs and an increase in integration and exchangein knowledge tend to attract an increasing concentrationof regional cluster-based FDI as opposed to fragmentedglobal-based FDI (Bjorkman & Forsg ren, 20(M); Buckley,Clegg, Forsans, & Reilly, 2(K)1). These regional clustersof value-added activities are used as springboards forexports, particularly to member countries.Limitations

First, our study is restricted to the consideration ofmacro political risk factors, excluding micro risk factors.While useful, our goal was to assess political risk ofcountries at the macro level only for both exporters andforeign direct investors. It would be worthwhile to inves-tigate political risk from both the macro and micro per-

spectives in the future. Also, we limit our sample to firmsfrom one country and thus to firms within a commoninstitutional framework that "shape(s) the direction of theacquisition of knowledge and skills" (North, 1990, p.78).Since the focus of our study is on Canadian firms, it isdifficult to generalize whether these results are applicableto MNCs from other countries."Second, our framework examined political and eco-nomic factors with the exclusion of social factors as aseparate dimension. While level of economic develop-ment may have social correlates such as social fragmen-tation and conflict developed along lines of ethnicity,religion, tribes, and so forth, future research shouldinclude social factors such as ethnic and religious con-flict, terrorism, and crime. Current trends indicate that,in many countries, terrorism and ethnic conflicts are onthe rise (Alon & Martin, 1998). Most notably, the attackson the Worid Trade Center on September 11. 20()l,

brough t the terrorist threat to the forefront in politicalrisk assessment and led to an increase in demand forpolitical risk insurance (Garton. 2004). Subsequentattacks in the United Kingdom and Spain showed thatterrorist attacks may happen anywhere in the world, evenin countries normally considered to be politically safe.Thus, the threat of terrorism exists globally and likelyaffects not only the assessment of political risk but alsoits management.Finally, although two rounds of survey letters weresent to respondents, the net response rate was only 11%.The use of Uuger samples in the future would certainlybe desirable particulariy if this study is to be extended tomultiple countries in a cross-cultural setting to test therobustness of the findings.

Directions for Future ResearchSince the "first boom" of the 1960s and 1970s, polit-ical risk has undergone some significant changes with theemergence of more subtle forms of government interfer-ence (Wells Jr., 1998). This "new breed of risks" {Minor,2003) is subtle and arises very gradually. Expropriationstoday are more likely undertaken by local and regionalgovernments than by central governments. New govern-ments may negate existing agreements rather than expro-priate assets outright, for example by revoking explorationlicenses (Minor). Also, gradual economic changes mayresult in significant political risks, such as the suddenlyintroduced inconvertibility ofth ek xa l currency. Researchinto the impact of different levels of government onpolitical risk would be beneficial for firm.s that need toassess their political risk exposure.There is also a dearth of studies on how political riskassessment ought to be tailored to different entry modes


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POLITICAL RISK AND THE INTERNATIONALIZATION OF HRMS AGARWAL & FEILS

in foreign markets. Our paper took a first step at lookingat political risk assessment for exporting and FDI. butother means of entering foreign markets need to be con-sidered. In the area of licensing, what is still unclear isthe impact of country and political risk on the net flowof licensed technology. For instance, while expectedprofits from licensing tend to reduce with country risk,higher risk might actually make licensing more appealingthan FDI (Smith, 2001). Another paradox that is unre-solved is whether strong intellectual property rights (IPR)enhance the net flow of licensed technology, since astrong iPR framework can trigger both market expan-sion, by reducing transaction cost, as well as marketpower, by raising the opportunity cost of licensing(Fosfuri, 2004; Smith, 2001), Clearly, there is a need toexamine carefully the various entry m odes of intemation-alization and the specific political risk scenarios associ-ated with each entry modality within an integratedtheoretical framework. Political risk and hazards withinthe framework of transaction cost economics seems to bea promising theoretical template.'"

Finally, our results indicate that exporters andforeign direct investors are increasingly concerned withred tape, from bureaucratic inefficiency to corruption.We need to examine the threshold point beyond whichred tape becomes more of a politica! problem rather thanan administrative one. When do good rules turn bad inthe evolution of red tape? By identifying the forces thatlead to the formation of red tape and the processes bywhich good rules turn bad, theoretical advancements canbe made in an otherwise scantily researched area{Bozeman. 2000; Bozeman & Scott, 19%). Perhapspolitical risk analysis should focus on political and socialinitiatives that influence positive reforms in governanceinfrastructure rather than changes in govemment itself(Globerman & Shapiro. 2003).In conclusion, while the evolutionary character ofpolitical risk changes, it is hoped that the movementtoward rapid globalization with more open and freemarket economies and tighter international laws, coupledwith the growing popularity and stringent mandate of the

W T O . would present new signs of life in our efforts toaddress p olitical risk challenges of the 21 " century.However, multinational firms in their path to internation-alization need to be cognizant of the emergence of a newbreed of political risks that is much broader in scope andsubtler in form and will likely affect all facets of theirinternational activities.Notes

1 Of th e different commercialfirmsproviding country politi-cal risk assessments, only Political Risk Services (FRS)

provides a differentiated analysis for exporting and FD(Howell & Chaddick. 1994). For example, the CophnO'Leary system of PRS categorizes export-related political risk as primarily consisting of market risks, imporrestrictions and protectionism, delays in payments andnonpayments, foreign exchange, and economic and political stability. On the other hand. FDI-related poUficid risprimarily includes restrictions in equity own ership, controof local operations , discriminatory practices of host countrygovernments, repatriation of funds, and political stabilityOn a similar note, very litile is known about the impact ocountry or political risk on contractual agreements.

2 We do not consider political risk toi financial institutionssince we focus on non portfolio Investment.3 Backward internaiionalization might also involve entrymode change from wholly-owned FDI to partial-ownedFDI. such as joint ventures and strategic alliances, to contractual agreements such as licensing and franchisingHowever, in our study, we limit the entry mode to FDand export only.4 It should be noted, however, that while the stages modehas received empirical support, albeit mixed results, thmain limitations are the time-dependant processes andeterministic evolutionary paths (Anderson. 1997), Recenstudies have shown that the stages theories are less validfor large firms and firms in the high-lechnology and services sector (Bell. 1995; Bjorkman & Forsgren. 2000)Global strategic factors, market factors, transaction-specific factors, and government-induced factors often moderate the entry and timing strategies of firms durininternationalization {Maihotra et al,, 2003).5 Fin ns wilh FD! operations periodically perform politicarisk assessments, and poor foreign market performance opotential for superior performance elsewhere might causmanagement to rethink the mode of operation. Onresponse is for firms to engage in partial withdrawals suchas subsidiary shutdow ns from multiple subsidiaries locatein multiple l(x;ations. This de*escalation is viewed as highly probable outcome in situations where alternativinvestment opportunities exist that arc more attractiv(Benito & Welch. 1997; Drummond, 1995).6 Tlie samples are sourced from two completely nonov erlapping databases (export sample from BOSS database anFDI sample from Who Owns Whom database). Second, iour survey questionnaire we asked the following pertinenquestion: What is your company's present main mode ointernational involvemeni (i.e.. expoil or FDi).' Fach respondent checked only one category even when both optionwere presented in this question. FDI firms checked the FDcategory and expon firms checked the export category,7 A sample question reads as follows: Kindly rate the folowing factor in terms ol its importance in assessing thpolitical risk of a country before making exporting anforeign direct investment decisions.

Exporting Foreign Direct, . " InvestmentNot NotAt All Extremely Al All ExtremelImportant Important Important ImportanD e g r e e o f 1 2 3 4 5 6 7 1 2 3 4 5 6 7R e d T a p ei n H o s t


15/18

TOI.ITICAL RISK AND THE INTERNATIONALIZATION OF HRMS AGARWAL & FEILS

Counirj' Government (e.g., excessive administrative layersand comiplion)8 We performed additional analysis using both repeated mea-sures within-subjects MANOVA and between-subjectsMANO VA after c ontr ollin g for ;v/c)/';>(/((,s7rv(i,e.. in dus-trial versus consumer type) by using it as a covariate.Multivariate test was marginally significant lor tbe between-subject design (Wilk's Lambda 0.612, F = 2.09. p = .06)and n onsignificant tor the w ith In-subject design (Wilk'sLambda 0,807, F = 0.79, p = .64). On furtber examinationof tbe iiniviiriate results for tbe between-subject design,the covariate "type of industry" was significant only forthe following two factors for tbe export function: level ofprotectionism (F = 6.66, p = ,013) and stability of foreignexcbange rates (F = 6,75. p = .013). Type of industry wasnonsignificant for the factors for the FDI function.9 A two-gr oup discriminant analysis was also conductedand provided consistent results.10 Similarly, a two-grou p discriminant analysis was also con-ducted and provided consistent results.11 Existing evidence shows that the institutional and national

background impacts tbe risk-attitude and risk-takingbehaviour of firms. Some factors that may intluencc Iherisk-attitude of firms include the prevalence of insiderownership (Carpenter, Pollock. & Leary. 2(M)3). the cul-tural environment (Lee & Peterson. 2000). and the politi-cal and legal environment (Gonzalez. 2005; Lee &Peterson. 2000), Strategic choices of firms are often influ-enced by their institutional framework. Thus, firms fromdifferent institutional environments (e.g., Canada andCzech Republic) may incorporate political risk assess-ments differently when making decisions on internationalexpansion (Makhija & Steward. 2OO2i Peng, 2O()2),12 Outsou rcing is increasingly becoming an important busi-ness activity in the international production process. While

not new. the practice became a popular term, activity, andresearcb topic in tbe 1990s, Throughout the past threedecades, manufacturers (in industries such as textile, steeland automobiles, for example) and more recently, serviceproviders, have increasingly outsourced production activi-ties and transferred work to external firms. In outsourcing,as in exporting, there are no physical facilities at risk;however, the damage to the finn may be significant if tbesupply cbain is interrupted (Doig, 2005). Political riskanalysis in tbe outsourcing sector provides a fertile groundfor systematic researcb for the future.r References

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agarwal e feils political risk and the inter nationalization of firms an empirical study of...

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